BY: EMMA WISCHMEYER & FLO CUADRA

Oligopoly

Oligopoly

Definition: A market dominated by a few large producers of a homogenous or differentiated product.

Characteristics

Because of the small number of oligopolists, they have considerable control over their prices, but each must consider rivals on the topics of pricing, output, and advertising decisions.

Characteristics

Producers: Has few large producers which is pretty vague

because the market model of oligopoly covers much ground, ranging from pure monopoly, on one hand, and monopolistic competition, on the other.

For Example: oligopoly encompasses the US aluminum industry, which 3 huge firms dominate the entire national market, and 4-5 much smaller auto-part stores enjoy roughly = shares of the market in a medium size town.

Characteristics

Products: An oligopoly can either be homogenous or

differentiated, depending on if the firm is producing standardized or differentiated products.

Many industrial products (steel, zinc, copper) are virtually standardized products.

Many consumer good industries (tires, cereal, cigarettes) are differentiated oligopolies, engaging in non-price competition supported by heavy advertising.

Characteristics

Control Over Price: Each firm is a “price maker” because there is

only a few. They must consider how its rivals will react to

any change in price, output, product characteristics, or advertising. (unlike the monopolist)

This is characterized by Mutual Interdependence: a situation in which each firms profit depends no entirely on its own price and sales strategies, but also on those of its rivals.

Characteristics

Entry Barriers: The same barriers to entry that create pure monopoly

also contribute to the creation of oligopoly. Economics of scale (important in rubber and cement

industry) Large expenditure for capital- the cost of obtaining

necessary plant and equipment- required for entering certain industries.

Ownership and control of raw materials. Patents Conclusion: entry of new competitors through

preemptive and retaliatory pricing and advertising strategies.

Characteristics

Mergers: The merging/combining of 2 or more

competing firms may substantially increase their market share, and may allow the new firm to achieve greater economics of scale.

Another motive for merging is the desire for monopoly power.

Industry Concentration

Most used measures are concentration ratios and Herfindahl Index.

Concentration Ratios

Concentration Ratios reveal he percentage of total output produced and sold by an industry’s largest firms.

Short Comings of this method:

Localized Markets: concentration ratios pertain to the nation as a whole, where the markets for some products are highly localized, so the representation isn’t extremely accurate.

Industry Competition: competition between 2 products associated with different industries. Concentration ratio understates the competition in some industries.

World Trade: doesn't take into account import competition of foreign suppliers. For example- the motorcycle and bicycle industry. A table showed that four US firms produced 65% of the domestic output of those goods, but ignored the fact that a very large portion of those 2 products bought in the US are imports.

Herfindahl Index

This index is the sum of the squared percentage market shares of all the firms in the industry, which solves one of the shortcomings previously listed, and explained below.

Example: In industry X one firm produces all of the output, in another industry, Y, there are four firms who each have 25% of the market. The C-ratio for both of these industries is 100%. Industry X is a pure monopoly, and Y is an oligopoly facing significant economic rivalry. Most economists would say that market power is greater in X than Y, a fact disguised by their identical 100% concentration ratios.

Herfindahl Index Formula

(%S1)^2 + (%S2)^2 + (%S3)^2 + … + (%Sn)^2

By squaring the percentage market shares of all firms in the industry, the index gives much greater weight to larger, and more powerful, firms than smaller ones.

To generalize, the larger the index, the grater the market power within an industry.

Game-Theory Model

Oligopoly pricing behavior has the characteristics of certain games of strategy, such as poker, chess, and bridge.

The best way to play those games depends on the way your opponent plays. (Again bringing up the idea that you always have to take into account your rival in oligopoly)

The study of how people behave in strategic situations is called game theory.

Game-Theory Model

Game Theory Model to analyze pricing behavior of Oligopolists

We assume a duopoly (2 firm oli.) producing athletic shoes. RareAir and Uptown each has a choice of pricing high or pricing low.

The profit each firm earns will depend on the strategy its rival chooses.

Continued… There are 4 possible combinations of strategies for the

two firms shown below. For example: cell C represents a low-price strategy for Uptown and a high-price strategy for RareAir. The figure below is called a payoff matrix, because each cell shows the payoff (profit) to each firm hat would result from each combo of strategies.

Mutual Interdependence Revisited

Oligopolistic firms can increase their profits, and influence their rivals’ profits, by changing their pricing strategies.

Each firms profit depends on its own pricing strategy and that of its rivals.

This mutual interdependence is the most obvious point demonstrated in the previous slide.

If Uptown adopts a high-price strategy, its profit will be $12 million provided that RareAir also employs a high-price strategy. (cell A)

Collusion

Collusion = cooperation with rivals which is beneficial to oligopolists in some cases.

It is an agreement among firms or individuals to divide a market, set prices, limit production or limit opportunities.

How can Oligopolists avoid low profit outcomes?

The answer is that they establish prices competitively independently. In the previous example, the two firms could agree to establish and maintain a high-price policy. So each firm will increase its profit.

Practices that suggest possible collusion include:

Uniform prices A penalty for price discounts Advance notice of price changes Information exchange

Three Oligopoly Models1) Kinked-demand curve

2) Collusive pricing

3) P Leadership

Why not a single model??? Two reasons, people:

4) Diversity of Oligopolies: great range and diversity of market situations= tight/loose oligopoly; differentiated/standarized products; collusive/non-collusive behavior; strong/weak barriers of entry…

5) Complications of Interdependence: because firms cannot predict the reactions of their rivals, they cannot estimate their own demand and marginal-revenue data, without which they can’t set their profit-maximizing P and Q.

Kinked-Demand Theory, a.k.a. Noncollusive Oligopoly Say there are 3 independent firms: A, K and D, each

having about one-third of the total market for a

differentiated product.

What does de Demand curve look like???

The location and shape of an oligopoly’s demand curve depend on how the firm’s rivals will react to a P changed introduced by A.

Again, two options: 1) Match P changes: K and D will match A’s

P change. This will cause A to increase its sales modestly, since K and D will also cut their P.

A’s Demand Curve

A’s Marginal-revenue curve

2) Ignore P Changes: K and D might choose to ignore A’s P change. This will make A increase its sales.

If A increases its P and K and D don’t, K and D will have their sales increased. However, this doesn’t mean that A will lose all of its customers Product differentiation might cause some customers to prefer A’s product, despite the P increase.

Kinked-Demand Theory, a.k.a. Noncollusive Oligopoly

A’s Demand Curve

A’s Marginal-revenue curve

A Combined StrategyA firm’s rivals will match P declines below P0, in

order to prevent the P cutter from taking their customers.

A firm will ignore P increases above P0, because the rivals of P-increasing firm stand to gain business lost by the P booster.

Demand is highly elastic above P0

Demand is less elastic or even inelastic below P0

Kinked-Demand Theory, a.k.a. Noncollusive Oligopoly

Noncollusive oligopolist’s Marginal-revenue curve

Noncollusive oligopolist’s Demand Curve

P Inflexibility:Why are P’s generally stable in concollusive

oligopolistic

industries??? Demand and cost reasons

1) Demand: oligopolists tend to believe that, because of the kinked-demand curve, a change in P will be for the worse. If P , the sales won’t increase by much because rivals will tend to P. If P , the firm will lose customers.

If Demand is inelastic, a in P will marginal revenue, and an in P, will only total costs.

2) Cost: the broken MR curve suggests that even if an oligopolist’s cost change substantially, the firm may have no reason to change its P. in all positions of the MC curve between MC1 and MC2 will result in the firm’s deciding on exactly the same P and Q.

Kinked-Demand Theory, a.k.a. Noncollusive Oligopoly

MR =MC at output Q0, for which will charge P0

Kinked-Demand Theory, a.k.a. Noncollusive Oligopoly Criticisms of the Model:The KD analysis doesn’t explain how the P is set

at P0. It only helps explain why oligopolists tend to stick with an existing P.

When the macroeconomy is unstable, oligopoly prices are not rigid. Ex: inflation periods (too many P ), recessions (price war successive cut prices).

Cartels and Other Collusion Oligopolists might benefit from collusion

(when firms in an industry reach an agreement to fix prices, divide up the market, or restrict competition among themselves.

By controlling P through collusion, oligopolists may be able to reduce uncertainty, increase profits, and prohibit the entry of new rivals.

P and Output:Each firm finds it most profitable to charge the same P,

but only if its rivals do so.

What can F, L, and O do??? collude!! (agree on P charged)

Collusion will reduce possibility of P wars and give each firm the maximum profit.

…sounds like the industry is a pure monopoly composed of 3 identical firms…

Cartels and Other CollusionConsider 3 firms: F, L,

and O.

Overt collusion: CartelCartel: a group of producers that typically

creates a formal written agreement specifying how much each member will produce and charge.

Sufficient market power to control output and price (which usually is set above the MC of production), and divide market.

Most famous cartel: OPEC (Organization of Petroleum Exporting Countries)

Cartels and Other Collusion

Cartels and Other Collusion Covert Collusion:Cartels are illegal in the US (antitrust laws). Any

collusion that exist is secret.

Tacit understandings: agreements between competing firms on product price made at cocktail parties, golf courses, through phone calls…

Obstacles to Collusion:1) Demand and Cost differences each oligopolist has different costs

and demand curves- Industries that produce differentiated products experience frequent

change. - Industries that produce standardized products may produce with

differing degrees of productive efficiency.- Profit-maximizing P differs among firms

2) Number of Firms: the larger the number of firms, the more difficult it is to collude.

3) Cheating: There is still a tendency to offer a lower price to steal competition

4) Recession: Slumping markets increase ATC

5) Potential Entry: Higher prices attract more firms, usually smaller

6) Legal Obstacles: Antitrust Law : prohibit cartels and price fixing

Cartels and Other Collusion

Price Leadership Model

A dominant firm ( largest or most efficient) initiates price changes and everyone else follows the leader.

This is a way in which oligopolies can coordinate P’s without engaging in collusion.

Price Leadership Model

Leadership Tactics :1) Infrequent price changes :P is changed only when

demand and cost has been changed significantly

2) Communications : the P leader communicates the need to raise/lower prices so other firms can react

3) Limit pricing: set prices below profit-maximizing level in order to discourage other companies from entering the industry

4) Breakdowns in Price Leadership: Price Wars : P leadership usually ends when one company undercuts the other companies and a price war results

Oligopoly and Advertising

Each firms share of the total market is best determined by product development and advertising

- Product development and advertising are less easily duplicated then price cuts and therefore can produce longer lasting gains

- Oligopolists generally have capital to put into product development

Oligopoly and Advertising

Advertising is prevalent in monopolistic and Oligopolistic competition

Positive effects of advertisements: Spreading information about products helps people make rational discussions and break up monopolies, enhances competition greater economic efficiency

Negative effects of advertising: some ads convey little about product attributes, too costly advertising campaigns can be canceling

Oligopoly and Efficiency

Productive and Allocative efficiency:The oligopolist’s production usually occurs

where P exceeds MC and ATC. Moreover, production is below the output at which ATC is minimized.

Neither Productive efficiency (P=min. ATC) nor Allocative efficiency (P=MC) is likely to occur.

Oligopoly and Efficiency

Points of view:Negative: informal collusion among oligopolists may yield

P and output results similar to those under pure monopoly, yet give the outward appearance of competition involving independent firms.

Positive: - Foreign competition has increased among different

oligopolistic industries (steel, photographic film, copy machines).

- Some oligopolists may intentionally keep their prices low.

- Oligopolistic industries may foster more rapid product development and greater improvement of production techniques through technological advance.